1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 31 Unemployment Fluctuations and the NAIRU

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-2 In this chapter you will learn to 5. Describe policies that might be used to reduce unemployment. 1. Describe how employment and unemployment change over the short and long runs. 2. Describe the difference between the New Classical and New Keynesian views of unemployment fluctuations. 4. Explain why the NAIRU can change. 3. Describe the causes of frictional and structural unemployment.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-3 Changes in Employment Employment and Unemployment The long run: - changes in employment roughly match changes in the labor force The short run: - employment and unemployment fluctuate considerably - the labor force is more stable

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-4 Changes in Unemployment Unemployment usually falls during booms and rises during “slowdowns”: - short-run fluctuations Over longer periods, unemployment changes more due to structural changes in the labour force.

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-5 The level of activity in the labor market may be better shown by the flows into and out of unemployment: - a million of workers flow in both directions each month! Flows in the Labor Market The focus on job creation and job destruction can often lead us to the conclusion that few changes are occurring in the labor market when in fact the truth is exactly the opposite.

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-6 Consequences of Unemployment 1. Lost output and income - a waste of resources 2. Personal costs - loss of self-esteem and dislocation of families Two important costs associated with unemployment are:

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-7 Unemployment Fluctuations Cyclical unemployment: - the difference between actual unemployment and the amount that would exist when Y = Y* When Y = Y*, there is still some unemployment: - frictional - structural Central question: What causes unemployment fluctuations?

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-8 Figure 31.1 U.S. Unemployment Rate, 1976–2006

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-9 APPLYING ECONOMIC CONCEPTS 31.1 Stocks and Flows in the Labor Market Labor Market Stocks and Flows

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-10 New Classical Theories According to New Classical theories, shocks to technology and tastes can explain unemployment fluctuations. Two major characteristics of New Classical theories: 1. agents continuously optimize 2. markets continuously clear - wage and price flexibility plays a leading role

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-11 New Classical explanations therefore look for reasons why employment fluctuates. Any unemployment that may exist is voluntary. EXTENSIONS IN THEORY 31.1 A Closer Look at New Classical Theory New Classical Theories

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-12 Figure 31.2 Employment and Wages in a New Classical Labor Market

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-13 Figure 31.3 Unemployment and Sticky Wages in a New Keynesian Labor Market Wages are sticky and the market does not clear  involuntary unemployment or labor shortages

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-14 2. Menu Costs and Wage Contracts Continuously changing prices and wages are costly. Many firms change them only occasionally. Four different explanations for wage “stickiness”: 1. Long-Term Relationships In labor markets in which long-term relationships are important, the wage rate does not fluctuate to continuously clear the market.

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-15 3. Efficiency Wages Firms may find it profitable to pay higher-than-market- clearing wages so that workers put forth greater effort. 4. Union Bargaining Wages may be more influenced by “insiders” than by “outsiders” — this may keep wages high, even in the face of declining demand. Four different explanations for wage “stickiness”:

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-16 Convergence of Theories? Both theories predict that in the long run, the unemployment rate comes back to U* (NAIRU). But they differ strongly in the short run: - New Classical models predict U is always U*  SR is no different than LR - New Keynesian models have U away from U* until LR  clear distinction between SR and LR

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-17 Table 31.1 Summary of New Classical and New Keynesian Theories

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-18 What Determines the NAIRU? Frictional Unemployment Frictional unemployment is caused by the time required for labor to move from one job to another: - search behavior is important - voluntary or involuntary? EXTENSIONS IN THEORY 31.2 Voluntary versus Involuntary Unemployment

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-19 Structural Unemployment Structural unemployment is due to a mismatch between what employers want and what workers have: - regional mismatches - occupational or industrial mismatches Structural unemployment will rise if: - there is a greater pace of structural change in economy - some government policies restrict mobility

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-20 Figure 31.4 Unemployment Rates in Selected OECD Countries, 2006

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-21 The Frictional-Structural Distinction Common characteristic: - both suggest that there are as many unfilled vacancies as there are unemployed persons Despite different conceptual meanings, it is often difficult to clearly distinguish the two types of unemployment.

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-22 Why Does the NAIRU Change? 1.Demographic shifts - greater labour-force participation by groups with high unemployment rates increases NAIRU - youths (15-24) tend to have much higher unemployment rates than “prime age” (25-65) individuals

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-23 Figure 31.5 Unemployment Rates by Demographic Groups, 2007

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-24 2. Hysteresis In some models, the level of NAIRU can be influenced by the level of the actual rate of unemployment - this effect is called hysteresis - the unemployed might become “unemployable” as their skills wear out - the “insiders” may keep wages high following a negative shock Why Does the NAIRU Change?

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-25 3. Globalization and Structural Change If the pace of structural change increases, the NAIRU will rise. - trade liberalization might have this effect 4. Policies Any government policy that reduces labor-market flexibility is likely to increase the NAIRU. Why Does the NAIRU Change?

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-26 Reducing Unemployment Cyclical Unemployment There is debate over how much government can and should do to reduce cyclical unemployment. Advocates of stabilization policy call for expansionary fiscal and monetary policies to reduce persistent recessionary gaps. Advocates of the hands-off approach rely on normal market adjustments to remove recessionary gaps.

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-27 Frictional Unemployment Increasing firms’ and workers’ knowledge about market opportunities may reduce frictional unemployment. Employment insurance is one important policy: it permits valuable searching for good matches but it also might encourage “too much” job searching But such measures are costly, and they must be balanced against the benefits.

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-28 Structural Unemployment There is a social interest in reallocating resources to where they are most valuable: - often conflicts with entrenched private interests Two policy approaches to reduce structural unemployment: 1.Resisting Change −maintaining employment levels in declining industries 2.Assisting Adjustment - increase retaining - improve the flow of labor-market information

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-29 Conclusion Government policy has generally followed a middle route between those who believe that unemployment is a sign of deep, systemic flaws in the market system and those who argue that it is a necessary evil of the market system. In an era of global competition, countries will be increasingly challenged to balance the need to cooperate with change and the need to provide a humane social welfare system.